Caring About Sunk Costs: A Behavioral Solution to Holdup Problems with Small Stakes

Economics students need to be taught that opportunity costsare important for optimal decision making but that sunk costsare not. Why should this be? Presumably these students havebeen making optimal decisions all their lives, and the conceptsshould be easy for them. We show that caring about sunk costscan help agents achieve efficient investments in a simple teamproduction environment. Furthermore, the solution we proposeis uniquely efficient if the environment is sufficiently complex.Hence, in addition to explaining contract form and ownership(Williamson, 1975; Hart, 1995), studies of the holdup problemmay also provide insights into observed behavior in day-todaybilateral bargaining problems.